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The Tax-Cut Question

Mises Daily: Tuesday, April 10, 2001 by

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In deciding on a tax cut, Americans must make a choice.

Will we make the same mistake as Britain's Labor government of 1945, which reluctantly cut taxes, targeting the cuts to ensure that none went to the rich? Or will we follow the route of the German Federal Republic of the late 1940s and 1950s, which repeatedly cut taxes across the board and thus triggered "the economic miracle" that led the German economy to become the strongest in Europe?

We have casebook studies of how tax cuts can actually hurt and help an economy. They can be used, not as weapon for helping regenerate an economy, but as a method of social engineering and promoting egalitarianism. This was the policy of England's first powerful socialist government, the Clement Atlee ministry of 1945. (The other Labor ministries, back in the 1920s, were weak governments in which Labor had to cut deals with other parties.)

At the end of World War II, Labor won a landslide victory and had one of the strongest governments in British history, with an overall majority of 145 seats. With little opposition from the Tories, Labor proceeded to nationalize many basic industries and to implement socialized medicine. Under the leadership of Hugh Dalton, chancellor of the Exchequer, it also offered tax policies to try to stimulate the economy. 

Dalton knew that cutting taxes was essential, but his philosophy was very similar to that of today's quasi-socialists pols who complain that President George W. Bush's proposed tax cut is too big and is a sop for the rich. Echoing many of John Maynard Keynes's ideas, these socialists believe big tax cuts will not help the economy because the rich will just save more money, while the poor and middle class will consume more.

In October 1945, Dalton offered a plan that called for a 40-percent cut on the lowest tax brackets,  a 10-percent tax cut on the middle brackets, and no tax cut on the highest brackets. In fact, Dalton went ahead with an increase in the already high surtax on the highest brackets. As one historian of this period wrote, while the general level of income tax went down, the level of the super tax went up, so that rich people were no better off.

It was apparent what Dalton was trying to do. He saw tax policy as another opportunity to advance British collectivism. He said his tax policies were intended "to continue the steady advances toward economic and social equality we have made during the war and which the Government firmly intends to continue in the peace."

Britain, which had many economic advantages over its continental neighbors in 1945, was headed for economic disaster—a disaster that, by the 1960s and '70s, would be called the British disease, a disease of low growth rates. One reason for these mistaken policies in 1945 was that the opposition party, the Tories of Winston Churchill, did little to oppose the puny tax-cut policy of Atlee/Dalton—much like today, when some American conservatives question if the nation can afford tax cuts.

In a reply to Labor's budget message, Conservative Shadow Minister John Anderson generally praised it, but he had a few minor complaints. Britain was on the road to more socialism through "targeted tax cuts." But there was a problem with Labor's tax and economic policies. The economy would stall. Growth was sluggish. Food rationing and other controls were still going on years after the war. People grumbled. Living under a socialist government, complained novelist Evelyn Waugh, was "like living under an army of occupation."

By 1948, Dalton's successor, who continued unsuccessful wage, price, and profit controls, was raising taxes on investment income. And because the economy wasn't recovering and because Britain desperately needed more income for its welfare–warfare state, he raised taxes on alcohol, tobacco, and sports pools—taxes that hurt more than the rich. By 1949, as the problems continued, the British pound had to be devalued by about 30 percent, to $2.80. By 1950, Labor's majority was down to only seven. Two years later, the Labor ministry was gone. The economic policies of reluctant tax cuts—tax cuts designed to further social engineering—failed. 

Meanwhile, in the German Federal Republic, Finance Minister Ludwig Erhard, a student of the Austrian School of economics, took a courageous step: He ended wage and price controls without the permission of the occupying forces. In 1948, he began a remarkable series of tax cuts and tax reforms that went on for a decade. In addition to benefitting both the rich and the poor, these reforms continually redefined who "the rich" were by pushing the income thresholds up at the same time that tax rates were being cut.

Erhard apparently wasn't interested in destroying the rich. Rather, his tax policy was to encourage more people to become rich. In this period, the dividend income tax rate was dropped from 65 percent to 15 percent, something Hugh Dalton and his socialists successors would have found terrible. 

In the process of trying to restore an economy, Erhard rediscovered something that helped Germany boom: Cutting taxes across the board was as successful as it was contagious. So, Erhard continued it repeatedly throughout the 1950s. Erhard became a very popular man and was able to ride his economic record into the chancellor's office in the 1960s. Dalton and his socialist colleagues, meanwhile, were not able to win office again for twelve years.

In sum, let's examine these two schools of tax cutting. 

On the one hand, there are the Hugh Dalton social engineers. They resemble modern Puritans, whom  Mencken once described as having an uncomfortable feeling that someone, somewhere is enjoying himself. The Dalton Gang, wherever it appears, believes it would be a sin if a tax cut were to lead to rich people becoming richer. They are suspicious of almost anyone who achieves quick wealth, so they believe cuts should be reserved only for the poor and middle class. 

Of course, how one defines the latter group is a dicey proposition in a country like America, where most of us consider ourselves middle class and many of us want to become rich. Only by loading up the tax benefits for those most likely to consume--the poor and the middle class--will the economy ever become stronger, the social engineers say. These Puritans also want to use tax cuts as a way of redistributing income. 

These people, either consciously or unconsciously, are usually socialists with a passion for equality. If they're baseball fans, they likely hate the New York Yankees. The logic of their thinking would be that each major league team should be allowed to win the World Series every thirty years or so. Liberty must be sacrificed to the crusade for equality, and tax policy is the Republican Guard of this socialist army of economic Comstocks.  

There is more than economic thinking going on with our modern Puritans: They often hate the rich. But their crusade is dangerous and could end up killing a lot of innocent people. 

Who are the rich? And who will define what is rich? And if they turn out to include people who have had some success in business or investing--a group that has taken in tens of millions of Americans over the past two decades--should we all hate ourselves?

On the other hand, there is the much larger tax-cut school. These people usually call for permanent cuts in marginal rates. They often say that their kind of fatter tax cut is not designed to promote income redistribution, nor as a form of social engineering.

What counts with these folks is that the economy grows, regardless of whether the distribution of the benefits is uneven. This is the best part of their program. Some of the more responsible of these people advocate lower taxes but simultaneously hold government spending in line. 

However, some irresponsible supply-siders argue that, given the additional tax revenues generated by the stronger economy, government spending can be jacked up. For instance, the U.S. could go on a military spending binge or some other government spending drunk, as it did after the successful marginal cuts of the early 1960s under President John Kennedy, a big-government president who used tax cuts as a way to pay for his insane and superfluous military buildup.

Of course, the small-tax-cut Puritans point to these supply-side spending-binge types to prove their specious case that huge tax cuts aren't good for an economy. They also point to them to prove that tax cuts will only work if they are smaller and are used as one of their weapons of social engineering. 

There is no doubt that one can criticize both the Puritans and some of the supply-siders. However, responsible supply-siders--those who want the deepest cuts possible and who don't advocate them as a way of continuing to pay for more big government, such as the ridiculous Reagan military buildup of the 1980s--are the ones whose victory would do the most good. History has proved their case time and again.

Americans must choose. Is it to be "economic and social equality" in a stagnating economy? Or is it to be the only policy that ever produces growth: huge tax cuts without a socialist agenda? 

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Gregory Bresiger, a New York-based financial writer, has appeared often on Mises.org. See his archive and send him Mail.